04 May 2010

It's difficult to imagine a more frightening scenario for tech startup founders.Envision a small bootstrapped tech venture hiring a software engineer, with family connections and a proven track record of competence and trustworthiness, to perform coding work from his home in a remote out-of-state location.The engineer is paid solely in shares.He receives no benefits and no tax withholding occurs.No written agreement between the engineer and the company exists.

Now imagine that this engineer suddenly perceives inequitable behavior among the founders.Disputing the notion that he's an employee, this engineer claims for the first time, after nearly a year of development, copyright ownership over the source code he's written, and deletes every copy of the code from all company computers, including the laptop PCs of the co-founders. He alone holds the only copy of the company's heart, blood and soul.He refuses to release the code until his demands for more equity are met.

Imagine then that the founders bring a lawsuit against this engineer, asserting that the engineer is in fact an employee, that the company owns the code in question, and as such, the engineer by his actions committed misappropriation of the company's trade secrets.After an extensive factual and legal record is established, the court of appeals affirms judgment in favor of the company on the issue of copyright ownership of the code, but against the company on the trade secret misappropriation claim.Surprisingly, the developer faces no legal consequences for his ransoming of the company's valuable trade secrets.

The recent case of JustMed, Inc. v. Michael Byce, No. 07-35861 (9th Cir. April 5, 2010), presents this exact factual and legal scenario, and recounts the story of two brothers-in-law embarking on a entrepreneurial adventure that takes an acrimonious and costly turn for the worse.

In the mid-1990s, Joel Just and Michael Byce co-developed a hands-free digital audio larynx to facilitate speech for those whose larynx had been surgically removed.Both have double-E degrees and are both tech company veterans.In 1998 they secured a patent to their invention.

Shortly after the patent issued, however, the company was hit with tragic news: the sudden and unexpected death of the wife of Byce and the sister of Just.No activity takes place again until 2003, when Joel and Ann Just form JustMed, Inc. in Beaverton, Oregon, to continue development of the product.

Joel Just offers and Byce accepts 130,000 founder shares in exchange for $25,000 cash, and Byce takes a position on the board.He begins work with another engineer in the company, Jerome Liebler, to create the hardware prototype and embedded software that runs it.

No one in the company was working for salary at this time.All were paid in shares.Cash to pay company expenses originated from angels in the form of family and friends, and from a loan from the Justs.

By the summer of 2004, the company finally had a product ready to market, "JusTalk".At this point, Byce took over complete development of the software from Liebler, who moved to Kentucky and assumed a less active role in the company.Byce's sole compensation at this time came in the form of 15,000 shares per month, valued at fifty cents a share.However, no written employment agreement or other writing documenting the relationship existed.The company issued no W-2s, paid no workers' compensation or unemployment insurance for Byce, and processed no tax, Social Security or Medicare withholding.

Byce worked from home, using his own computer, in Boise, Idaho.Byce set his own hours, often working late into the night.Communication with the rest of the company took place solely via emails and telephone calls.Byce would periodically send over new versions of the source code to Just in Beaverton.Just never made any modifications to the code, trusting Byce's skill over his own.Eventually Byce had nearly completely re-written Liebler's code.

Byce had a company business card and company title, and was listed as an employee in the company profile brochure.He attended conferences and conducted product demonstrations, and performed marketing duties in addition to his development responsibilities.

By May 2005, Byce, who had been living off credit, became concerned about his financial situation and requested that half his compensation be paid in cash.Just agreed, Byce signed a W-4, and the company issued three paychecks to Byce as salary for May, June and July of 2005 – checks that Byce never cashed.

The checks were not cashed because, by this time, Byce had convinced himself that he was not being treated fairly.Apparently realizing that if he started accepting cash salary, his status as an employee would be difficult if not impossible to contest, Byce refused the cash.

What followed next is best recounted by a direct quote from the Ninth Circuit's opinion:

At this point, Byce became concerned that Just did not view him as an equal in the corporation.In order to protect what he perceived as his intellectual property, Byce changed the copyright statement on the software, so that it now read “Copyright (c) Mike Byce 2005” instead of copyright JustMed.

Then, while Byce was working in the Oregon office two days before Just was scheduled to meet with a potential merger or buy-out partner, Byce deleted all copies of the source code from JustMed’s computers. Byce testified that he made the decision after seeing a spreadsheet showing a large disparity between the number of shares Byce owned and those shares that the Justs and Liebler owned. In its memorandum decision, the district court found that Byce deleted the code to gain leverage over Just in Byce’s efforts to acquire a greater share of the company. The next day, Byce raised with Just the disparity in ownership between Byce and the other primary shareholders. The two talked for several hours, but Just declined to give additional shares to Byce. During this conversation, Byce did not mention that he had deleted the source code from JustMed’s computers.

Just still had a recent version of the object code loaded on a JusTalk unit, but after flying to Chicago for his demonstration meeting, Just could not get the unit to work. Hoping this was a curable problem, Just tried to recompile the source code on his laptop and then load it onto the unit, only to discover that he no longer had a copy of the source code. Just called Byce about the missing code, but Byce claimed to have assumed “revision control,” meaning that he had removed the source code to insure that no one else would make changes to it.

Only upon returning to Oregon did Just realize that Byce had deleted the source code from all of JustMed’s computers. Just was able to recover some prior versions of the source code files, but not the most recent one. Byce later returned the latest version of the source code, with some of the programmer’s notes removed, but only after JustMed filed suit against Byce and the Idaho state court issued a temporary order.Because Just did not trust the code he received from Byce, JustMed has since worked from older versions of the code to develop the device.

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The US Copyright Act's default rule of copyright ownership is that the creator or author owns the copyright to the work in question.One exception arises in the situation in which an employee creates works on behalf of and in the scope of employment for an employer.In this case, the employer is deemed to be the owner from the outset.If however the developer is not an employee but is instead classified as a contractor, the exception does not apply and ownership remains with the contractor.

The Ninth Circuit affirmed the district court's judgment that Byce was an employee, based on the following factors:

i)Byce was not hired for a specific term or with a defined end in mind.The parties envisioned an indefinite relationship.

ii) Byce performed other work for JustMed in addition to product development and programming, such as web site maintenance and marketing work, thus suggesting that the company could have assigned additional non-programming related tasks to Byce.And, the formal title that Byce gave himself ("Director of Engineering") was indicative of broad duties and permanence of position.

iii) The Ninth Circuit characterized the shares that Byce received as "salary", paid "in the same way as other JustMed employees".

iv) Byce's work was critical to the success of the product and to the company's future.

That Byce worked from home, set his own hours, and directed his own work, was not viewed as dispositive, but rather endemic to the type of work that Byce was doing in the environment that he was doing it in.

The strongest argument Byce marshaled in support of his claim that he was never an employee stemmed from the company's failure to pay benefits and complete the appropriate payroll forms, and the company's tax treatment of Byce.The Ninth Circuit dispensed with this argument by noting the unique characteristics of small technology startups:

JustMed’s treatment of Byce with regard to taxes, benefits, and employment forms is more likely attributable to the start-up nature of the business than to Byce’s alleged status as an independent contractor. The indications are that other employees, for example Liebler, were treated similarly. Insofar as JustMed did not comply with federal and state employment or tax laws, we do not excuse its actions, but in this context the remedy for these failings lies not with denying the firm its intellectual property but with enforcing the relevant laws.

As a small start-up company, JustMed conducted its business more informally than an established enterprise might. This fact can make it more difficult to decide whether a hired party is an employee or an independent contractor, but it should not make the company more susceptible to losing control over software integral to its product.

Having found that Byce was in fact an employee and therefore that the company is the rightful owner of the source code, the Ninth Circuit turned to resolution of JustMed's trade secret misappropriation claim.It was undisputed that the source code was JustMed's trade secret, and that Byce was under a duty, under the Idaho Trade Secrets Act, to maintain the code's secrecy and limit its use.

The Court of Appeals first noted that Byce's disclosure of limited parts of the code to the US Copyright Office, in an attempt to obtain copyright registration in his own name, "is not necessarily inconsistent with maintaining the secrecy and value of the trade secret".The Copyright Office policy is to deny direct public access to in-process files, and after registration issues, the Copyright Office releases reproductions of the work "under limited circumstances", the Court observed.

As this was the only form of disclosure that occurred, the Court next considered whether Byce had "used" the code in violation of his duty to protect the company's trade secrets.The term "use" as utilized in the Idaho Trade Secrets Act "generally contemplates some type of use that reduces the value of the trade secret to the trade secret owner," the Ninth Circuit noted.In this case, Byce filed for a copyright registration and threatened permanent loss of the code for the company, but this use, the Court of Appeals held, did not diminish the value of the code or its secrecy. As the code had been fully returned to JustMed, no harm or diminution in value occurred.

The district court had awarded JustMed damages of $41,250, to compensate for the salaries of Just and Liebler for the three months they spent in recreating the source code Byce had deleted.The Ninth Circuit overturned this award:

These damages, however, do not reflect damages from Byce’s use, as opposed to his mere possession, of the source code. Byce returned the source code to JustMed after the court ordered him to do so. His possession of the source code for some period of time did not result in a loss of secrecy or a loss in value, which is evident from the fact that the court did not award damages for lost value or unjust enrichment. Thus, not only are damages not appropriate under Idaho law, but neither is a finding that Byce misappropriated the source code.

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What could be a more common occurrence among tech startups in the Valley:an early employee of a tech startup, paid in shares, working from home, with no benefits, no tax withholding, and no written agreement between the staff member and the company.

Founders of most venture companies would not necessarily expect that such staff would be considered employees subject to tax withholding and employee protection regulations. Yet, at the same time they expect the company will own all intellectual property rights to the inventions and software such staff create.

The JustMed decision's value is the lesson it gives all tech startup founders: always require everyone who works for you, whether they are doing so for cash or stock, or as employees or contractors, to sign a Proprietary Information and Inventions Agreement (PIIA), which clarifies the company's sole ownership over the staff member's creations and mandates an irrevocable assignment of intellectual property rights for inventions and code. Had Byce signed such a document, Byce would never have been able to hold the JustMed code for ransom in the way that he did.

The other lesson to be learned here is that classification of staff members as employees or as contractors, particularly software engineers working from home in exchange for shares, is tricky business. Don't assume that such staff will be considered to have the status you intend. Make a determination, after consultation with your attorney, and comply with all necessary tax and reporting obligations associated with that determination, and thereafter act consistently with that decision.

The bitter irony for JustMed is that its apparent victory over Byce in its claim that Byce was at all times an employee, thus confirming JustMed's ownership of the source code, now means that Byce may have claims against the company resulting from the courts' post hoc determination of an employment relationship over a period of several years.

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About Me

Sean Hogle specializes in technology, intellectual property, and commercial law for clients in the software, wireless, Internet, emerging media, concept art and special effects space. Sean is an expert in open source and is a frequent lecturer and writer on the topic. Prior to forming his own firm, Sean was Vice President and General Counsel of Aplix Corporation, based in Tokyo, a consumer and embedded software company and the world's leader in wireless Java platforms. Prior to joining Aplix, Sean worked for a large law firm in Denver, Colorado, where he got his start in the technology law field, before he eventually joined Sun Microsystems, at which he became Assistant General Counsel responsible for software and technology licensing and alliances for Japan and the Asia Pacific region. Sean's seventeen years of experience in technology enables him to act as a "virtual general counsel" to his venture clients around the globe. Sean is based in his firm's San Rafael, California office, in the San Francisco Bay Area.